Considerations for Investors in Light of the Madoff Scandal
As recently reported in the press, investors in international market maker Bernard L. Madoff Investment Securities LLC (the “Madoff Fund”) have been defrauded in amounts that could reach $50 billion. The founder of the Madoff Fund, Bernard L. Madoff, allegedly advised senior employees last week that the Madoff Fund’s high returns were achieved by use of a traditional Ponzi scheme in which investors receive abnormally high returns out of the money paid in by subsequent investors, rather than from the profit from any real business. Both Mr. Madoff and the Madoff Fund are now the subject of various proceedings, including a civil action filed by the Securities and Exchange Commission in the United States District Court for the Southern District of New York. Although Madoff has not yet filed for personal bankruptcy, the Madoff Fund has been placed in a liquidation proceeding in the United States Bankruptcy Court for the Southern District of New York. The Trustee appointed over the Madoff Fund by the Securities Investor Protection Corp. (SIPC), has been directed to effectuate an orderly liquidation of the business of the Madoff Fund and to commence such litigation as appropriate for the return of funds. It is likely that further actions will be brought by private parties.
Although the list of claims and counterclaims that will result from this alleged fraud are too numerous for this brief alert, it is important that investors be aware of certain important matters at the outset.
The primary considerations for Madoff Fund investors are not only what remedies are available to them, but also what actions may be commenced against Madoff Fund investors. For example, those investors who qualify as customers under SIPC may recover up to $500,000 of their investments. On the other hand, Madoff Fund investors may find themselves the subject of litigation as defendants for redemption payments or distributions received.
In In re Bayou, a bankruptcy case in the Southern District of New York involving a hedge fund, the Court held that redemptions may be fraudulent conveyances and as such, must be returned to the bankruptcy estate. The look-back period, known in the nomenclature of bankruptcy as the “claw-back,” is two years. The basis for the various Bayou complaints (over 110 have been filed) is that the defendant-investors were paid more than their investments were worth and such payments were made by the hedge fund with the intent to defraud. The defendant-investors were thus charged with having received fraudulent conveyances under the Bankruptcy Code. Madoff Fund investors may find themselves subject to similar proceedings. Further, while the federal claw-back is two years, the relevant state Debtor-Creditor law may provide for a more extensive look back period, such as the six years under New York state law. There are various affirmative defenses that can be raised by an investor-transferee to these actions, including the good faith of the investor.
Investors should also be aware of the tax consequences as a result of the failure of the Madoff Fund. In addition to any losses taken this year as theft losses, taxpayers who paid income taxes on “profits” from the Madoff Fund in prior years may be eligible for a refund. However, tax returns may only be amended for the prior three years under current statutes of limitations. As claims for the 2005 tax year will be barred on April 15, 2009, affected taxpayers may wish to immediately seek competent tax advice to protect their claims for refunds. Furthermore, if charitable deductions were taken (i.e. if the funds were transferred directly to charities), the tax deduction may be disallowed, and additional taxes assessed if the facts show that the purported transfer was not effective as a gift because there were no assets to give.
Finally, the Madoff story is a wake-up call for all of us wherever we are invested. Investors should consider how their holdings are diversified among asset classes and across investment vehicles and financial advisors, and whether there are sufficient checks and balances in place to assure investors that the assets are secure.